capital requirements
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A capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a
bank A bank is a financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state ...

bank
or other
financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entit ...
has to have as required by its
financial regulator Financial regulation is a form of regulation Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slight ...
. This is usually expressed as a
capital adequacy ratioCapital Adequacy Ratio (CAR) is also known as ''Capital to Risk (Weighted) Assets Ratio'' (CRAR), is the ratio In mathematics, a ratio indicates how many times one number contains another. For example, if there are eight oranges and six lemons in ...
of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with
reserve requirements Reserve or reserves may refer to: Places * Reserve, Kansas Reserve is a city in Brown County, Kansas, Brown County, Kansas, United States. As of the 2010 United States Census, 2010 census, the city population was 84. It is located approximate ...
, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds not a use of funds.


Regulations

A key part of bank regulation is to make sure that firms operating in the industry are prudently managed. The aim is to protect the firms themselves, their customers, the government (which is liable for the cost of
deposit insurance Deposit insurance or deposit protection is a measure implemented in many countries A country is a distinct territorial body or political entity A polity is an identifiable political entity—any group of people who have a collective identit ...
in the event of a bank failure) and the economy, by establishing rules to make sure that these institutions hold enough capital to ensure continuation of a safe and efficient market and are able to withstand any foreseeable problems. The main international effort to establish rules around capital requirements has been the
Basel Accords The Basel Accords refer to the banking supervision Accords (recommendations on banking regulations)—Basel I Basel I is the round of deliberations by central bankers A central bank, reserve bank, or monetary authority is an institution tha ...
, published by the
Basel Committee on Banking Supervision 300px, BCBS headquarters. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten (economic), Group of Ten countries in 1974. The co ...
housed at the
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution An international financial institution (IFI) is a financial institution that has been established (or chartered) by more than one country, and hence is subject ...

Bank for International Settlements
. This sets a framework on how
bank A bank is a financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state ...

bank
s and
depository institution Colloquially, a depository institution is a financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a group of people or a company—authorized by th ...
s must calculate their
capital Capital most commonly refers to: * Capital letter Letter case (or just case) is the distinction between the letters that are in larger uppercase or capitals (or more formally ''majuscule'') and smaller lowercase (or more formally ''minusc ...
. After obtaining the capital ratios, the bank capital adequacy can be assessed and regulated. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as
Basel I Basel I is the round of deliberations by central bankers A central bank, reserve bank, or monetary authority is an institution that manages the currency A currency, "in circulation", from la, currens, -entis, literally meaning "runnin ...
. In June 2004 this framework was replaced by a significantly more complex capital adequacy framework commonly known as
Basel II Basel II is the second of the Basel Accords, (now extended and partially superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The Basel II Accord was published in ...
. Following the
financial crisis of 2007–08 Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricatu ...
, Basel II was replaced by Basel III, which will be gradually phased in between 2013 and 2019. Another term commonly used in the context of the frameworks is
economic capital __NOTOC__ In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money ...
, which can be thought of as the capital level bank shareholders would choose in the absence of capital regulation. For a detailed study on the differences between these two definitions of capital, refer t
Economic and Regulatory Capital in Banking: What is the Difference
The capital ratio is the percentage of a bank's capital to its
risk-weighted asset Risk-weighted asset (also referred to as RWA) is a bank's asset In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be ...
s. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Basel II requires that the total capital ratio must be no lower than 8%. Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework. Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a bank's capital ''eroded by the yearly inflation rate''. The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Covenants- have been replaced by one single criterion. While the international standards of bank capital were established in the 1988
Basel I Basel I is the round of deliberations by central bankers A central bank, reserve bank, or monetary authority is an institution that manages the currency A currency, "in circulation", from la, currens, -entis, literally meaning "runnin ...
accord,
Basel II Basel II is the second of the Basel Accords, (now extended and partially superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The Basel II Accord was published in ...
makes significant alterations to the interpretation, if not the calculation, of the capital requirement. Examples of national regulators implementing Basel include the Financial Services Authority, FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy. In the United States the primary regulators implementing Basel include the Office of the Comptroller of the Currency and the Federal Reserve. In the European Union member states have enacted capital requirements based on the Capital Adequacy Directive CAD1 issued in 1993 and CAD2 issued in 1998. In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with assets, balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and Derivative (finance), derivatives and Foreign exchange market#Financial instruments, foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be ''adequately capitalized'' under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be ''well-capitalized'' under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. Although Tier 1 capital has traditionally been emphasized, in the Late-2000s recession regulators and investors began to focus on tangible common equity, which is different from Tier 1 capital in that it excludes preferred equity. Regulatory capital requirements typically (although not always) are imposed at both an individual bank entity level and at a group (or sub-group) level. This may therefore mean that several different regulatory capital regimes apply throughout a bank group at different levels, each under the supervision of a different regulator.


Regulatory capital

In the
Basel II Basel II is the second of the Basel Accords, (now extended and partially superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The Basel II Accord was published in ...
accord bank capital has been divided into two "tiers" , each with some subdivisions.


Tier 1 capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity and disclosed reserves. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $20 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $300. Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities. In India, the Tier 1 capital is defined as "'Tier I Capital' means "owned fund" as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a systemically important non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;" (as per Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007) In the context of NBFCs in India, the Tier I capital is nothing but net owned funds. Owned funds stand for paid up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any.


Tier 2 (supplementary) capital

Tier 2 capital, supplementary capital, comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.


Undisclosed reserves

Undisclosed reserves are where a bank has made a profit but this has not appeared in normal retained profits or in general reserves.


Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.


General provisions

A general provision is created when a company is aware that a loss has occurred, but is not certain of the exact nature of that loss. Under pre-International Financial Reporting Standards, IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.


Hybrid debt capital instruments

They consist of instruments which combine certain characteristics of equity as well as debt. They can be included in supplementary capital if they are able to support losses on an ongoing basis without triggering liquidation. Sometimes, it includes instruments which are initially issued with interest obligation (e.g. debentures) but the same can later be converted into capital.


Subordinated-term debt

Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10 years and ranks senior to Tier 1 capital, but subordinate to senior debt in terms of claims on liquidation proceeds. To ensure that the amount of capital outstanding doesn't fall sharply once a Lower Tier 2 issue matures and, for example, not be replaced, the regulator demands that the amount that is qualifiable as Tier 2 capital amortises (i.e. reduces) on a straight line basis from maturity minus 5 years (e.g. a 1bn issue would only count as worth 800m in calculating capital 4 years before maturity). The remainder qualifies as senior issuance. For this reason many Lower Tier 2 instruments were issued as 10 year non-call 5 year issues (i.e. final maturity after 10 years but callable after 5 years). If not called, issue has a large step - similar to Tier 1 - thereby making the call more likely.


Different international implementations

Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction. For example, it has been reportedBoyd, Tony, "A Capital Idea", 21 October 2008
/ref> that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Prudential Regulation Authority (United Kingdom), Prudential Regulation Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.


European Union

In the EU countries the capital requirements as set out by Basel III agreement have been implemented by the so-called Capital Requirements Directive, CRD IV package which commonly refers to both the EU Directive 2013/36/EU and the EU Regulation 575/2013.


Common capital ratios

*CET1 Capital Ratio = Common Equity Tier 1 / Credit risk-adjusted asset Value ≥ 4.5% *Tier 1 capital ratio = Tier 1 capital / Credit risk-adjusted assets value ≥ 6% *Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 + Tier 2) / Credit risk-adjusted assets ≥ 8% *Leverage Ratio = Tier 1 capital / Average total consolidated assets value ≥ 4%


See also

*
Basel II Basel II is the second of the Basel Accords, (now extended and partially superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The Basel II Accord was published in ...
*Basel III *Reserve requirement *Capital adequacy ratio * KVA, the XVA, x-Valuation Adjustment for regulatory capital


References


External links


The Basel I AccordFDIC Call and TFR Data
{{Authority control Capital requirement, Insurance